Banks

China

Chinese Banks
Cash Cushions Thinning as Liquidity Erodes and Forbearance Burdens Rise
Special Report
In this Report
Chinese Banks ....................................... 1 Core Drivers of Funding and Liquidity Erosion ................................................... 2 Numerous Indicators Signal the Erosion of Funding and Liquidity ........... 5 Funding and Liquidity Erosion Means Thinner Cash Cushions ......................... 7 Looking Ahead ..................................... 11 Appendix Update on Wealth Management Offerings ............ 13

Financial Sector Challenges Growing: Three years after the onset of the global crisis, China faces a growing list of its own financial sector challenges threatening to undermine economic growth and financial stability. At the heart of these issues is the aggressive counter-cyclical credit policy enacted by authorities in response to the 2008 crisis, which has fuelled a massive build-up of leverage in the formal and informal banking sectors, given rise to large excesses in real estate and infrastructure, eroded financial sector liquidity, and boosted inflation. Recent Stress not Unique: Recent stress in informal lending and among property developers, SMEs, and local governments has not reached systemic levels. Nonetheless, Fitch Ratings believes these are not isolated cases of distress, but rather emblematic of excesses from the credit boom and a policy orientation that overly relies on credit controls and low fixed-interest rates; prioritises the state sector above private companies and savers; and favours forbearance and support over restructuring. In this light, recent problems could be only the beginning. Liquidity Strain Before NPLs: Over the near term, Fitch expects the authorities to continue a selective policy of forbearance and liquidity support for borrowers, including loan rollovers and restructurings, new loans, and bond issuance. As a result, asset quality issues may not fully appear in NPL ratios until well into a deterioration, if at all. Instead, delinquencies will manifest themselves first as liquidity stress, as cash inflows from distressed borrowers slow and more resources are directed to support weak entities. Near-Term Dislocations Unlikely: Banks cash positions are already under strain, and a rising forbearance burden will only add further claims on these resources. For now, the CNY21trn in commercial bank credit capacity plus CNY16trn in deposit reserves is sufficient to prevent any major short-term dislocations. But if current rates of erosion continue, it is conceivable that cash constraints in 2012 could become more binding. Some small banks have a dwindling capacity to extend new credit, and may require substantial relief in reserve requirements. Conditions Today Are Different: Although prolonged forbearance has been successful on numerous occasions this time Chinese banks are entering the credit cycle with significantly weaker liquidity and a much larger stock of financing to carry. Unlike the last run-up of bad loans in the 1990s, there is no force like WTO accession on the horizon to propel the economy out of its difficulties. It is because of this cash constraint that current asset quality stress has the potential to become more destabilising than in previous episodes of loan deterioration. Thinning Cash Causing Stress: Weakening cash cushions explain with what appear to be clean balance sheets and solid earnings, Chinese banks encountered system-wide liquidity crunches in January and June 2011, why banks are paying 300bp above base rates in auctions of Ministry of Finance (MOF) deposits, and why market-driven interest rates continue to climb. Carry Costs Crimp Growth: As forbearance burdens rise and funding and liquidity become more constrained, the less resources Chinese banks will have to continue financing new economic activity while meeting their own obligations and extending forbearance. In this way, the high carry costs of the credit boom could begin to crowd out GDP growth as banks get progressively bogged down by supporting the recent run-up in leverage. Viability Ratings Under Pressure: The rapid erosion of Chinese banks historical funding and liquidity strengths is a concern, and could lead to negative action on some Viability Ratings,with the ratings of smaller banks with thinner liquidity being the most vulnerable.

Analysts
Charlene Chu +8610 8517 2112 charlene.chu@fitchratings.com Chunling Wen +8610 8517 2105 chunling.wen@fitchratings.com Hiddy He +8610 8517 2135 hiddy.he@fitchratings.com

www.fitchratings.com

2 December 2011

Banks
Core Drivers of Funding and Liquidity Erosion
At the core of tightened funding and liquidity conditions are fundamental changes in monetary policy and financial institution regulation since the global crisis, some of which have been intentionally aimed at tightening liquidity and others unintentional. These shifts include: a switch in emphasis from mopping up foreign-currency inflows from open market operations to deposit reserve requirements, which are significantly more constraining for bank liquidity; de facto deposit rate liberalisation, by allowing banks to compete for deposits using wealth management offerings at yields of their own choosing, which has sparked unprecedented competition and made deposits more mobile than ever before; a relatively hands-off approach towards the emergence and growth of the shadow banking system, which has led to increased disintermediation of deposits into other channels; an accelerated push to internationalise the renminbi and open the capital account, which is leading to greater China-related financial activity outside the domestic banking system.

Greater Emphasis on Deposit Reserve Requirements

A common complaint from banks and borrowers in 2011 is that overly tight monetary policy has tied up too much liquidity, leading to a credit crunch in some parts of the economy. In many respects, this is true. The 600bp rise in deposit reserve requirements (RRR) since 2009 to 21% for major banks has indeed locked up CNY4.4trn in cash that would be free if the RRR remained 15.5%. Yet more than 60% of this drain has been offset by a contraction in central bank sterilisation bills, resulting in a net withdrawal of just CNY1.7trn by end-September 2011. In fact, an examination of the combined amount of Chinese banks required reserves and holdings of central bank bills shows that the average 15.9% share of banking sector assets tied up in liquidity management operations in 2011 is lower than the 16.2% average from Q108 to Q311, and is well below the peak of 17.7% in H109 (Figure 1). Nevertheless, although fewer funds overall are currently tied up with the central bank, a much larger share 85% compared with 50%-60% pre-2010 is coming from required reserves rather than purchases of central bank bills. This is critical because bill holdings can be sold if a bank is facing liquidity strains and in need of cash. In contrast, deposit reserves are 100% illiquid and cannot be drawn down, unless a bank can demonstrate a decline in its deposit base.
Figure 1

Shift in Sterilization Orientation Weighing on Bank Liquidity

(%) 21 18 15 12 9 6 3 0 2004
a

Required reserves

Excess reserves

Bank holdings of PBOC bills

2004

2005

2006

2007

2007

2008

2009

2010

2010

2011

Excludes bank holdings of restructuring-related PBOC bills Source: PBOC, CEIC, Fitch

Surging Wealth Management Offerings

Bank wealth management offerings quasi-substitutes for time deposits have been soaring in 2011 owing to a convergence of interests between banks eager to manage down deposit balances to avoid high reserve requirements and depositors seeking higher returns amid negative real savings rates (Figure 2; note that RRR charges are calculated on a rolling 10-day

Related Criteria
Global Financial Institutions Rating Criteria (August 2011)

Chinese Banks December 2011

Banks
Figure 2

No. of Domestic Banks' WMPs Outstanding

Index-linked AB other AB discounted bill-related Asset-backed (AB) loan-related 8,000 6,000 4,000 2,000 0 2007 2008 2009 2010 Q311 A large portion of these WMPs were previously grouped with bill-related WMPs Source: Wind Information
a

basis). Last year Fitch wrote extensively about a subset of activity focused on the informal securitisation of loans into investment products (see Chinese Banks: Informal Securitisation Increasingly Distorting Credit Data, July 2010). This is only one of many types of offerings, which are outlined in Figure 3. Fitch has long emphasised that the greatest risk associated with Chinese banks wealth management activity is the strain it places on funding and liquidity. This risk was easily controllable when the amount of outstanding products remained small; but with wealth management products (WMPs) issued by domestic banks now approaching 10% of total deposits, it is becoming increasingly difficult for Chinese banks to manage (see Appendix for more information on recent developments in wealth management activity). For banks, the benefits associated with WMP issuance stem from the ability to shift the assets and liabilities underlying WMPs on- and off-balance-sheet, which they typically do through strategically setting product start- and end-dates. This enables banks to lower deposit balances between periods to avoid high reserve requirements, while giving them the flexibility to bring the deposits back on-balance-sheet at period-end to pad loan/deposit ratios.
Figure 3

Types of Investment Products

(WMPs) Issued by, and Liabilities of, Banks Trust Products (TPs) Issued by, and Liabilities of, Trust Companies

Index- and Equity-Linked

Asset-Backed, ie, Informal Securitisation

Single Investor

Collection of Investors (CTPs)

Other AssetBacked

Credit-Related (CWMPs)

Investor is a Banka

Other Single Investor

Discounted Bill

Credit-Only

Credit-Mixed
Discussed in 2010 Fitch reports

Bank on-sells the product to investors as a bank wealth management product, for which the bank becomes liable Source: Fitch

Increased Depositor Mobility

The most salient consequence of the proliferation in wealth management offerings is the increased mobility of deposits. Whereas in the past a Chinese depositor earned the same interest no matter which bank he placed his money with, today he can shift his deposit to whatever entity offers the best WMP returns. Consequently, Chinas previously sticky deposits are losing their adhesiveness. For the first time, Chinese banks now have to contend with large deposit payouts as WMP investors pull their money and invest it elsewhere. This challenge is exacerbated by the fact that one-quarter of all WMPs issued in 2011 carried maturities of less than one month, meaning that WMP investors are continuously reassessing the landscape and deciding where to place their money next (Figure 4).

Figure 4

Maturities of Asset-Backed WMP Issuance

(%) 100 75 50 25 0 2007 2008 2009 2010 9M11 Source: Wind Information <90 days 181-365 days >2 years 91-180 days 1-2 years

Meeting Payouts a Challenge

If WMPs were structured so that investor payouts were evenly matched with the assets underlying the products, meeting these obligations would be relatively straightforward. However, most asset-backed WMPs, which have made up 99% of all products issued by domestic banks thus far in 2011, are not linked to any specific asset, but rather to a pool, whose cash inflows

Chinese Banks December 2011

Banks
Figure 5

Trends in 7-Day SHIBOR

(%) 8 6 4 2 0 Jan 10 Jul 10 Jan 11 Jul 11 Source: CEIC Mid-month rate Month-end rate

often do not match the timing of WMP payouts. When a mismatch exists and banks are unable to liquidate assets from the pool to pay back investors, they are left with three options: draw on their on-balance-sheet assets, resulting in an erosion of on-balance-sheet liquidity; use money raised from new WMP issuance to pay off old issuance, which is the most popular option, but which is highly dependent on confidence, market conditions, and interest rates; borrow the funds in the interbank market, which covers the immediate product payout but creates a new future liability.

While banks generally prefer the first two options, as liquidity has tightened there has been a growing reliance on interbank borrowing to repay product investors. Because a large share of WMPs are structured to mature at month-end thereby allowing the money to be brought back on-balance-sheet there has been an intensifying month-end scramble for cash to cover product payouts and the additional RRR allocation. This month-end crunch is highlighted in Figure 5, which shows the widened gap between seven-day SHIBOR rates at mid-month and month-end, which exceeded 170bp from August to October 2011. This gap narrowed significantly in November after the authorities began injecting liquidity into the interbank market. However, it is unclear how long this will last given the large stock of WMPs, approximately 40% of which have month-end maturities.

Increased Disintermediation from Expanding Shadow Financing

Like WMPs, Chinas rapidly growing shadow banking system has also been increasingly enticing depositors away from banks with offers of returns significantly above that of current negative real savings rates (-200bp for one-year deposits in October 2011). Whereas funds raised from the sale of WMPs at least stay within the banking system, deposits migrating to shadow banking are sometimes lost entirely. Much of this money does eventually return to the banking system, but often arrives in the form of loan repayments rather than new deposits. This results in an increase in cash holdings and a decline in loans, but no increase in funding. The authorities hands-off approach toward the development of shadow banking has fostered very rapid growth of this sector. Before the 2008-2009 global crisis, bank loans and transactional off-balance-sheet items accounted for more than three-quarters of all domestic corporate financing, but in 2011 this figure will fall to roughly one-half as new financing channels continue to expand. While the October investigations into informal lending may dampen activity on the margins, the reality is that Chinas economy today requires significantly more financing to achieve the same level of growth as in the past (Figures 6 and 7). Bank balance sheets are too stretched to provide the same share of financing as before. Hence, shadow channels must remain open in order to support growth, and disintermediation is likely to remain an issue for some time.
Figure 6

The 2011e forecast for the Fitchadjusted TSF has been revised to CNY17-17.5trn from CNY18trn in July 2011. Most of this change is due to a slowdown in components of the official TSF, while growth of Fitch add-ons remains robust (Figure 7).

Figure 7

Fitch-Adjusted TSF Add-ons

Gross credit from HK banks Additional securitised loans Credit from non-bank FIs Trust product credit Letters of credit

Trends in Total Societal Financing (TSF) and GDP

Change in nominal GDP (CNYbn) 18,000 12,000 6,000 0 Incremental 2005 change in GDP/ 0.76 net new financing Net new other financing (TSF) Net new credit-related financing (TSF) Fitch-adjusted TSF net new add-ons (Figure 7)

(CNYtrn) 5 4 3 2 1 0

H111

2006

2007

2008

2009

2010

Source: CEIC, Fitch, HKMA

2011e

2006 0.71

2007 0.77

2008 0.70

2009 0.18

2010 0.34

2011e 0.44

Source: PBOC, China Trustee Association, HKMA, Wind Information, CEIC, Fitch

Chinese Banks December 2011

Banks
Accelerated Shift of Activity Outside Domestic Banks to Offshore Channels
The push to accelerate the internationalisation of the renminbi and open the capital account has also contributed to erosion of funding and liquidity. The creation of the Dim Sum market for offshore renminbi issuance, the opening of renminbi-denominated trade settlement, Hong Kong banks aggressive expansion of credit to Chinese corporates and banks, and the robust growth of mainland citizens spending and investment abroad have led to an increasing amount of financing and settlements taking place outside the domestic banking system.
Figure 8

Hong Kong Banks Mainland China Exposures

(CNYbn) Non-bank mainland China exposurea Claims on mainland banks Sum: Gross mainland China exposureb Hong Kong GDP Gross mainland China exposure/GDPc (%)
a b c

2007 753 298 1,051 1,573 67

2008 765 297 1,062 1,495 71

2009 887 334 1,221 1,431 85

2010 1,413 921 2,334 1,519 154

H111 1,698 1,368 3,066 1,539c 199

Includes exposures booked in mainland subsidiaries of Hong Kong-incorporated institutions Approximately CNY300-400bn of this amount in H111 represents CNY re-deposited at the PBOC Average of end-2010 and Fitchs sovereign teams 2011 forecast of HKD1,944bn Source: HKMA quarterly bulletin, HKMA external liabilities and claims statistics, CEIC

By mid-November 2011, the outstanding amount of Dim Sum issuance stood at roughly CNY215bn. Meanwhile, Hong Kong banks mainland exposure had risen to CNY3.1trn as of end-June 2011 (Figure 8). Because of restrictions on capital inflows, a large portion of the money raised by Chinese companies offshore is not brought onshore, yet repayment of the obligations sometimes comes from onshore resources. In this way, there is an eventual drain of corporate deposits from the mainland banking system to offshore creditors, which may be one factor contributing to the recent increase in capital outflows from China.

Numerous Indicators Signal the Erosion of Funding and Liquidity

Since mid-2010, market-driven interest rates and numerous other indicators have been signalling a steady tightening of banking sector funding and liquidity (Figures 9 and 10). These data point to a fundamental, structural erosion underway that qualitatively differs from previous momentary episodes of tightness. Small joint-stock and regional banks have been the most under pressure due to their larger WMP portfolios and more limited, concentrated sources of funding, yet even Chinas large state banks have begun to demonstrate periodic strains.
Figure 9 Figure 10

Deposit Rates Diverging

3-mo. base deposit rate 3-mo. MOF deposit auction result 6-mo. base deposit rate 6-mo. MOF deposit auction result

Shift in SHIBOR Yield Curve Far Exceeds Change in Base Rates

H110 (%) 6 5 4 3 2 1 0 O/N 1-wk 2-wk 1-mo. 3-mo. 6-mo. 9-mo. 1-yr H111 H210 H211 to date a

(%) 8 6 4 2 0 Dec 06

Feb 08

May 09

Aug 10

Nov 11

Source: CEIC

Period average Source: CEIC

Thus far, liquidity pressure at state banks has been transitory. Nonetheless, it raises doubts about the conventional wisdom that these entities can provide a reliable first line of defence against an extended system-wide cash crunch. In January 2011 the Peoples Bank of China (PBOC) was forced to inject CNY1.3trn in cash into the banking system nearly twice the amount of any previous month on record in response to systemic stress related to RRR hikes,

Chinese Banks December 2011

Banks
Figure 11

Net New Deposits

Household Government Other Enterprise Fiscal

WMP volatility and the Chinese New Year. Similar injections could become more frequent if state banks funding and liquidity continue to weaken.

Deposit Composition Shifting

Among the most striking signs of the shifting funding environment has been the dramatic change in the composition of deposit growth. From end-2009 to end-Q311, enterprise deposits rose just CNY2.5trn, while deposits of government agencies and organisations which exclude fiscal deposits of the Ministry of Finance (MOF) at the PBOC rose by CNY7.8trn (Figure 11). The key drivers behind the recent growth of government deposits have been the rapid growth of local government land sales, which results in a net transfer of funds from corporates to local governments; the reclassification of some enterprise deposits as government-related; and the placement of some fiscal funds of the central government with commercial banks. The decline in enterprise deposits is often attributed to the migration of corporate savings into wealth management offerings. Although certainly a contributor, the fact that a large portion of WMPs are brought on-balance-sheet at quarter-end to boost loan/deposit ratios (see Appendix) suggests that quarterly enterprise deposit data may be less distorted than perceived. Meanwhile, the fact that household deposits (which account for more than half of WMP investment) do not show a similar trend, also indicates that other factors are at work, such as: the weakened operating environment for corporates, which face rising cash outflows from higher wages, input costs, and borrowing costs, matched by only muted growth of revenue; increased migration of enterprise deposits into shadow financing channels, and of enterprise fund-raising to offshore channels; less repatriation of Chinese companies overseas profits after a relaxation of rules that had previously required all overseas profits to be brought back to the mainland.

(CNYbn) 14,000 10,000 6,000 2,000 -2,000

2007 2008 2009 2010 9M11 Source: PBOC

Figure 12

New Deposits Per Month

(CNYtrn) 3 2 1 0 -1
May 11 Jan 08 Jun 08 Nov 08 Dec 10 Sep 09 Feb 10 Oct 11 Apr 09 Jul 10

Source: PBOC

Growing Disparity Between Interim and Period-End Data

Funding and liquidity challenges are also apparent in the increased volatility of deposit figures in both macro and institutional data. In 2011 system-wide deposits have demonstrated unprecedentedly large swings, particularly in the months before and after quarter-end (Figure 12), eg March/April (+CNY2.7trn/+CNY334bn), June/July (+CNY1.9trn/CNY669bn), September/October (+CNY730bn/CNY201bn). At an institutional level, this volatility is evident in the growing divergence between Chinese banks expected and average daily deposits. Figures 13 and 14 highlight the difference in H111 between the expected amount of daily average deposits implied by period-end balances and the actual daily average. For example, if a bank held CNY100 in deposits at end-2010 and CNY150 at end-H111, the expected daily average for H111 would be CNY125. However, the banks true average may have been only CNY105, indicating a weaker day-to-day funding position than period-end data would suggest.
Figure 13

Chinese Banks December 2011

Banks
In H111, the disparity between expected and actual daily average deposits widened almost across the board. Chinas five state banks whose actual average was spot on in H110 were carrying CNY730bn less deposits on a day-to-day basis in H111 than the level implied in their financials (excluding Bank of China (BOC, A/Stable) this figure is CNY979bn). As a share of deposits, the figures are even more stark for Tier 2 banks, whose combined daily average in H111 fell CNY167bn below their January 1 opening balance, or CNY430bn below the expected average. These figures highlight the growing disparity between the funding picture portrayed in Chinese banks financial statements and the day-to-day reality between periods
Figure 14

Trends in H111 Average Depositsa

Bank Industrial Bank (IND) China CITIC Bank (CITIC) Bank of Communications (BCOM) Industrial & Commercial Bank of China (ICBC) China Merchants Bank (MER) Shanghai Pudong Development Bank (SPDB) China Guangfa Bank (CGB, formerly GDB)b China Minsheng Banking Corporation (MIN) Agricultural Bank of China (ABC) Shenzhen Development Bank (SZDB) Bank of Shanghai (BOS) China Construction Bank (CCB) China Everbright Bank (CEB) Bank of Beijing (BOB)b Hua Xia Bank (HXB) Bank of China (BOC)c
a b c

Viability Rating b+ bb bb bb bb bb b+ bb b+ b+ bb bb b+ bb b bb

Actual minus expected average (CNYbn) -126 -143 -137 -448 -75 -57 -22 -37 -205 -13 -7 -189 -13 +3 +27 +249

Gap as % of actual average (%) -12.0 -8.9 -4.8 -4.0 -3.9 -3.9 -3.9 -2.6 -2.3 -2.2 -2.0 -2.1 -1.2 +0.6 +3.6 +3.7

Domestic operations only where data is available. See Figure 2 for a full list of ratings End-2010 BOC keeps a large share of its WMPs on-balance-sheet between periods, resulting in much lower volatility Source: Bank financial statements

It is difficult to identify how much of this disparity is related to funding that Chinese banks still retain but hold off-balance-sheet in wealth management offerings, as opposed to how much is temporary funding secured for short periods of time at quarter-end. However, even if the money is retained in off-balance-sheet WMPs, the short-term, highly mobile nature of such products means that this money is not a stable source of funding that can be relied upon.

Funding and Liquidity Erosion Means Thinner Cash Cushions

While there is a general consensus that financial sector risks in China have risen since the global crisis, opinions diverge widely over the likelihood of these risks reaching systemic proportions that threaten financial stability. In an environment where financial support for distressed borrowers is the norm, todays bad loan problems can easily be pushed into the future through loan rollovers and restructurings, new loans and bond issuance. The result is invariably low NPL ratios, regardless of broader economic conditions. In theory, such practices can continue indefinitely as long as bank shareholders are willing and able to provide this forbearance, and as long as other parts of the economy are strong enough to offset the drag on growth. However, the concern in China today is that the banking sectors forbearance burden is rising at a time when funding and liquidity are dwindling and financing needs remain high. For the first time, a large number of Chinese banks are beginning to face cash pressures, and fewer resources are available today than in the past to carry the economy through an extended period of forbearance. It is because of this cash constraint that the forthcoming wave of asset quality issues has the potential to become uglier and more destabilising than in previous episodes of loan portfolio deterioration.

Chinese Banks December 2011

Banks
Figure 15

Chinese Banks Cash Flow Cushions Have Thinned Dramatically (Unconsolidated)

Big 5 State-Owned Banks Tier 2 Banks with VRs bb- Jan-Dec Jan-Dec Jan-Dec Jan-Dec Jan-Dec Jan-Dec 2011e 2010 2009 2011e 2010 2009 9,367 8,423 6,138 3,361 2,467 1,850 4,212 5,155 14,531 1,427 9,622 3,482 5,164 8,617 4,334 4,283 5,839 5,107 732 2,386 11,041 0 4,247 4,176 10,978 1,014 7,490 2,474 2,555 5,919 3,680 2,239 5,535 4,990 545 2,171 8,919 0 3,146 2,992 10,907 1,256 7,462 2,189 4,770 6,393 5,215 1,178 6,918 6,501 417 5,295 7,529 0 1,343 2,018 3,191 303 1,054 1,834 -170 1,782 914 868 1,147 1,010 137 -805 2,935 27 988 1,479 2,253 183 873 1,196 -214 1,324 920 404 1,562 1,466 96 24 2,582 0 786 1,064 2,111 355 938 818 261 1,419 1,222 197 1,632 1,565 67 475 2,169 0 Tier 2 Banks with VRs b+/b Jan-Dec Jan-Dec Jan-Dec 2011e 2010 2009 2,637 1,906 1,533 1,336 1,301 2,112 118 427 1,566 -526 993 547 446 656 589 67 -863 1,570 55 996 910 1,548 141 322 1,085 -358 695 515 180 891 841 50 -162 1,315 12 791 742 1,350 183 396 771 -183 693 605 88 826 793 33 -50 1,254 4

(CNYbn) 1. Expected Cash Outflows, as identified at prior year-end a. Non-deposit liabilities b. Off-balance-sheet itemsa 2. Cash Inflows/Sources of Cashb a. Cash and excess reserves b. Tradable securitiesc c. Interbank assets 3. Expected Net Cash Position 4. Additional Operating Cash Outflows, current period a. Loans b. Estimated WMP payoutsd 5. Additional Operating Cash Inflows, current period a. Deposits b. Net incomee 6. Final Operating Cash Position 7. Loans less than 1 year 8. Share of loans less than 1 year that must be repaid (%)
a b c

Includes irrevocable loan commitments less than one year, acceptances, letters of credit, and unused credit card lines Average balance over the period Excludes pledged and illiquid securities such as loans and receivables, securities received during NPL carveouts, or investments in other banks WMPs d Assumes only 60% of maturing products must be repaid in cash e Income figures are not available on an unconsolidated basis, so consolidated figures are used instead. 2011e net income is 2x H111 net income Source: Bank financial statements, Fitch

Cash Positions Have Weakened Across the Board

While much has been written about Chinas surplus savings from an economic perspective, from a banking sector point of view the continuous flood of new, captive deposits has been the single most important factor upholding financial system stability through more than a decade of reform and commercialisation. Prior to the crisis of 2008-2009, the scale of new deposits entering the system each year was so immense and outflows so miniscule that whether a loan was repaid or not often had little impact on banks ability to meet their own obligations. Whether NPLs were 1% or 20%, deposits and other inflows were usually more than enough to cover all liabilities. This phenomena is most evident when examining Chinese banks cash flow positions, which are highlighted in Figure 15. Line 6 of this table shows how as recently as end-2010, two of the three categories of Chinese commercial banks under Fitchs coverage had final operating cash surpluses before receiving even a single yuan of loan repayment. However, since 2009, operating cash positions have thinned across the board as funding and liquidity have tightened, previously stable deposits have become more mobile, and financing needs remain high, forcing large amounts of credit into off-balance-sheet channels. By end2011, Tier 2 Chinese banks are expected to post a combined operating cash deficit in the region of CNY1.6trn, compared with a surplus of CNY425bn in 2009. State-owned banks are expected to continue to register a final operating cash surplus, albeit down by more than half from 2009. This dramatic shift in cash flow cushions means that Chinese banks ability to meet their own obligations increasingly depends on some portion of existing loans being repaid. Figure 15, Line 8 highlights the amount of loans maturing within one year that must be repaid in full in order for each group to cover short-term cash outflows through end-2011. For Tier 2 banks with VRs in the b category, 55% of loans coming due by end-2011 must be repaid in full, while

Chinese Banks December 2011

Banks
Figure 16

Operating Cash Flow Cushions Adjusted for 80% Repaymenta (CNYbn)

Big 5 State-Owned Banks Jan-Dec Jan-Dec Jan-Dec 2011e 2010 2009 9,367 8,424 6,137 13,610 4,243 10,044 5,839 38 11,041 0 10,306 1,882 6,666 5,535 751 8,919 0 10,353 4,216 6,786 6,918 4,348 7,529 0 Tier 2 Banks with VRs of bb- Jan-Dec Jan-Dec Jan-Dec 2011e 2010 2009 3,361 2,467 1,849 2,765 -596 2,071 1,147 -1,520 2,935 52 1,971 -496 1,459 1,562 -393 2,582 15 1,920 71 1,485 1,632 218 2,169 0 Tier 2 Banks with VRs of b+/b Jan-Dec Jan-Dec Jan-Dec 2011e 2010 2009 2,637 1,907 1,533 1,772 -865 1,142 656 -1,351 1,570 86 1,312 -595 755 891 -459 1,315 35 1,184 -349 722 826 -245 1,254 20

1. Expected Cash Outflows, as identified at prior year-end 2. Cash Inflows/Sources of Cash 3. Expected Net Cash Position 4. Additional Operating Cash Outflows 5. Additional Operating Cash Inflows 6. Final Operating Cash Position 7. Loans less than 1 year 8. Share of loans less than 1 year that must be repaid (%)
a

Assumes banks receive 80% cash repayment of interbank assets less than one year, corporate fixed-income securities are sold for 80% of their current value, and banks must pay out 80% of WMPs maturing within 1 year Source: Bank financial statements, Fitch

banks with bb category VRs must receive 27% repayments. These are striking changes from just one year ago. It should be noted that these results are conservative as they assume that: all reverse repos will be repaid in full on-time, which is optimistic given that some of these transactions are between banks and their own WMPs, and receipt of cash on this portion of repos is questionable (see Appendix); all non-reverse repo interbank assets less than one year in maturity will be fully repaid in cash on-time, which may not be the case given both declining liquidity among counterparty banks, who may push to roll over obligations, and growing concerns about the health of the nonbank financial sector; banks only have to pay out 60% of maturing WMPs, and experience no deposit outflows aside from these WMP payouts; all corporate fixed-income securities can be sold for cash at no loss when required, which is unlikely to be the case in a stress scenario.

Figure 16 shows the difference in key line items if only 80% of interbank and reverse repo assets are repaid in cash, only 80% of the value of corporate fixed-income securities can be retrieved, and banks must repay 80% of maturing WMPs. In this scenario, Tier 2 banks with VRs of b+/b must receive repayment of 86% of loans less than one year in maturity in order to meet their cash outflow obligations (versus 55% previously), while for banks with bb- VRs this figure rises to 52% from 27%.

Capacity to Extend Forbearance and Credit Is Dwindling for Small Banks

Extrapolating these results to an assessment of forbearance and lending capacity highlights how thinning cash flows could start to crowd out the ability of small banks to extend new loans and provide the support the authorities are counting on to smooth over asset quality issues. With b VR banks now requiring repayment of as much as 55%-86% of loans less than one year just to meet their own obligations, these entities have dwindling room to extend new credit, let alone provide assistance to distressed borrowers. As Figure 17 highlights, the credit capacity of these banks as they enter 2012 has plummeted to CNY200bn-700bn, compared with CNY900bn-1.4trn at the start of 2011. These figures are derived by taking the sum of lines 6 and 7 in Figures 15 and 16, which represent the amount of money left after all outgoing obligations are met. Whether these resources are extended as new credit or in the form of forbearance, i.e. the bank agrees to roll over the loan and the money is deducted from expected repayments, the effect on banks cash positions is the same.

Chinese Banks December 2011

Banks
Figure 17

Lending and Forbearance Capacitya,b

(CNYtrn) Scenario 1 from Figure 15 all interbank assets are fully repaid, all corporate securities are sold without loss, and only 60% of matured WMPs must be repaid. Scenario 2 from Figure 16 80% cash repayment of interbank assets, corporate securities sold for 80% of current value, and 80% of matured WMPs must be repaid.
a

Big Five State Tier 2 Banks with Tier 2 Banks with Banks VRs of bb VRs of b+/b 2012e 2011 2010 2012e 2011 2010 2012e 2011 2010 13.4 11.1 12.8 2.1 2.6 2.6 0.7 1.2 1.2

11.1

9.7

11.9

1.4

2.2

2.4

0.2

0.9

1.0

These figures are in addition to irrevocable credit commitments less than 1 year, which are incorporated in the analysis in Figures 15 and 16 and assumed to be fully met b Assumes that 96% of loans less than 1 year are repaid. At end-H111, NPLs and special mention loans amounted to 4% of gross loans in aggregate for these 16 banks Source: Bank financial statements, Fitch

At first glance, higher-rated Tier 2 banks lending/forbearance capacity would appear to be adequate for the coming year given that annual lending by these six entities has never exceeded CNY1.2trn. However, when considered in the context of the accelerating erosion of liquidity across the sector, it is conceivable that even these banks could begin to experience some crowding out. For example, these banks began 2011 with enough cash to lend CNY2.2trn-2.6trn, but as the year comes to a close these figures have dropped to CNY1.4trn-2.1trn. If this accelerated rate of funding and liquidity erosion persists, it is conceivable that soon only the big five state-owned banks will be in a position to consistently provide the magnitude of intermediation and forbearance required to prop up growth and forestall asset quality deterioration. After more than a decade of steadily declining market share, Chinas state banks may soon be returning to the forefront.

Cash Cushions are not Static

The exercise above reflects the current state of affairs in Chinas banking system. The results are not static, and can change if additional sources of funding are tapped (eg senior debt issuance or equity raising) or if significant policy changes occur (eg large RRR reductions or greater limits on WMP issuance). However, an increase in funding or cash cushions at any one entity does not necessarily equate to an improvement in the system-wide cash position, which in H111 could provide for approximately CNY37trn in lending/forbearance capacity. This is because monies collected through new fund-raising often come from somewhere else in the banking system eg state banks which purchase senior debt of smaller banks, SOEs drawing down deposits to subscribe to the rights issue of a joint-stock bank, or the PBOC releasing reserves to small banks. In each of these instances, resources are merely transferred from one balance sheet to another, and there is no net increase in liquidity at a system level. This is why the steady rise in interbank borrowing, while temporarily helping banks meet their immediate obligations, has done nothing to improve the overall liquidity situation. The only ways to ease system-wide pressures are through: strengthening organic deposit growth, which could be a challenge given the countrys narrowing current account surplus and moderating GDP growth, which itself is heavily dependent on loose credit; attracting new money from outside the domestic banking system, eg funds previously lost to shadow banking, corporate overseas profits, or money raised offshore; reducing deposit payout pressure by clamping down on short-term WMP issuance, which the authorities have begun to do;

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Figure 18

Required Short-Term Loan Repayment by Banks, 2011ea

Bank ICBC ABC CCB BCOM BOB MIN BOS SPDB BOC MER HXB CITIC IND SZDB CGBb CEB
a

accelerating broad money growth through reducing sterilisation operations and/or printing money, which have obvious negative implications for inflation, or through increasing the money multiplier by pressuring banks to lend, which would worsen leverage; lessening the forbearance burden on the banking system by providing some type of bailout package for the worst loans.

Required Payback of Loans < 1yr (%) 0 0 0 14 19 26 27 35 42 44 44 60 72 72 74 87

Resources Appear Sufficient for the Short-Term

For the time being, the current CNY37trn in system-wide credit capacity of which CNY21trn resides at commercial banks (more than CNY2.8trn of this is already committed) and the rest in the form of deposit reserves at the PBOC would appear to provide sufficient resources to prevent any major dislocations over the short term. That said, these resources are largely in the hands of the big five state-owned banks. Many small banks have a shrinking capacity to extend new credit or forbearance, and may require substantial RRR relief ahead. If current rates of funding and liquidity erosion continue, then looking into late 2012 and beyond, it is conceivable that certain parts of the system could begin to encounter significant cash constraints. This is particularly the case if forbearance burdens begin to rise appreciably, or if inflation remains elevated enough to prevent aggressive monetary easing. The authorities response to the SME crisis in Wenzhou suggests that banks may not only face pressure to support existing loans, but also potentially non-bank and other shadow financing, which now exceeds CNY20trn outstanding excluding offshore financing based on the Fitchadjusted TSF. The order not to recall loans to SMEs in distress, and to extend them new money to help pay off informal creditors, in essence transfers shadow banking exposures into the formal banking system. Although substantial, the current level of credit capacity is thinner than pre-crisis, having fallen to an estimated 77% of GDP or 2.1x the Fitch-adjusted TSF in 2011, from 95% of GDP or 4.3x the Fitch-adjusted TSF in 2008. If significant cash constraints do arise at some point, a choice will have to be made between loosening liquidity by accelerating broad money growth at the risk of re-igniting inflation and/or worsening leverage, or continuing to make due with existing resources. If inflation remains an issue and authorities must work within existing liquidity constraints, then some tough decisions may have to be made about whether to continue to direct large amounts of money into forbearance thereby limiting the amount of new credit to healthier borrowers and crowding out GDP growth or allowing dormant asset quality problems to finally begin working their way through the system. It is this cash constraint, rather than what NPL ratios may or may not signal, that ultimately matters, and could be what eventually forces the hand of the authorities with regard to a potential bailout further down the road.

Average of Scenarios 1 and 2 as laid out in Figure 17 b End-2010 Source: Bank financial statements, Wind Information, PBOC, Fitch

Looking Ahead
The analysis above demonstrates why with what appear on the surface to be relatively clean balance sheets and solid earnings the Chinese banking sector encountered system-wide cash crunches in January and June 2011, why banks are paying 300bp above fixed-base deposit rates in auctions of MOF deposits, and why market-driven interest rates continue to trend higher. Loan rollovers/restructurings, transfers of assets off-balance-sheet, and transactions with NBFIs may be preventing current stress from becoming apparent in NPL ratios, but cash positions clearly show that the banking system is under growing strain. Although prolonged forbearance has been successful on numerous occasions in the past, this time Chinese banks are entering the credit cycle with significantly weaker cash cushions and a much larger stock of financing to carry. Unlike the last major run-up of bad loans in the late1990s, this time there is no force like WTO accession on the horizon to propel the economy out of its difficulties.

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Looking into 2012, Fitch expects funding and liquidity will remain under strain as growth of wealth management offerings adds further WMP payout pressures, and borrower stress drives forbearance burdens higher. In H111, listed banks posted an increase in cash outflow obligations of 30% un-annualised (Figure 15, Line 1), compared to growth of cash inflows/sources of cash of just 12% (Figure 15, Line 2). Add to this decelerating deposit growth and increased pressure to lend, and it is difficult to see how liquidity and funding conditions can ease significantly absent substantial RRR relief. Going into next year, the Chinese banking sector faces four key risks, all of which could lead to a worsening of funding and liquidity erosion and place the system on an accelerated timetable toward future cash constraints: rising forbearance burdens due to growing repayment difficulties among borrowers, in particular local governments, property-related entities, and SMEs; further deceleration in deposit growth, which could result from slowing economic expansion, outflows of capital, or something as benign as a strong rebound in the equity market that would attract away household deposits as occurred in 2007; persistently elevated inflation, which, while falling, could remain high enough to prevent the authorities from aggressively easing liquidity conditions through RRR cuts; a freezing-up of the interbank market due to tightened liquidity at large state banks and/or heightened concern about the health of counterparties.

Given the rising level of stress evident in several aspects of Chinese banks operations including asset quality, capitalisation, funding and liquidity Fitch is becoming increasingly cautious about the medium-term outlook for mainland banks. These concerns could lead to negative action on some Viability Ratings in coming months, with the ratings of smaller banks with thinner cash cushions the most vulnerable (Figure 19).
Figure 19

Fitchs Ratings of Chinese Banks

Bank China Development Bank (CDB) Agricultural Development Bank of China (ADBC) Export-Import Bank of China (EXIM) Industrial and Commercial Bank of China (ICBC) China Construction Bank (CCB) Bank of China (BOC) Agricultural Bank of China (ABC) Bank of Communications (BCOM) China Merchants Bank (MER) China CITIC Bank (CITIC) China Everbright Bank (CEB) Shanghai Pudong Development Bank (SPDB) China Minsheng Banking Corporation (MIN) Bank of Beijing (BOB) Bank of Shanghai (BOS) Industrial Bank (IND) China Guangfa Bank (CGB, previously Guangdong Development Bank, GDB) Shenzhen Development Bank (SZDB) Hua Xia Bank (HXB)
a

Support Rating 1 1 1 1 1 1 1 1 2 2 2 3 3 3 3 3 3 3 3

Viability Rating NR NR NR bb bb bb b+ bb bb bb b+ bb bb bb bb b+ b+ b+ b

Long-Term Issuer Default Ratinga A+ A+ A+ A A A A A BBB BBB BBB BB+ BB+ BB+ BB+ BB+ BB+ BB+ BB+

The Long-Term Issuer Default Ratings (IDRs) of all 19 Chinese banks are based solely on expectations of state support Source: Fitch

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Figure 20

Appendix Update on Wealth Management Offerings

Wealth management offerings of Chinese banks continue to gain popularity as competition for funding intensifies, and negative real savings rates drive a search for yield. As regulatory scrutiny of loan- and discounted bill-backed products has risen, issuance has shifted toward non-credit-related mixed-asset products. By end-Q311, approximately 9.5% of total deposits had migrated into WMPs, with outstanding products reaching an estimated CNY7.7trn (Figure 20, 2010: CNY4.4trn, 2009: CNY2.3trn). Fitch considers the liquidity risk arising out of Chinese banks wealth management activity to be nearing a critical mass where it could begin to become destabilizing. As demonstrated earlier, the increased mobility of deposits and the constant, intensifying pressure to meet product payouts is eroding the funding and liquidity positions of banks across the sector. At the same time, product credit risk continues to be a concern, with upwards of CNY1.7trn in regular loans, at least CNY1trn in discounted bill loans, and several hundred billion in corporate fixed-income securities sitting in WMPs. The continued absence of strict guidelines requiring that assets and liabilities of WMPs be evenly matched means that the vast majority of products continue to be managed on a pooled basis. Given the extent to which wealth management offerings have grown, these pools have reached a magnitude where they are now akin to full-fledged hidden second balance sheets, containing a myriad of mismatched, undisclosed assets and liabilities, and nothing but onbalance-sheet capital and reserves to absorb losses.

Nominal Amount of WMPs Outstanding

(CNYbn) 8,000 6,000 4,000 2,000 0 2007 2008 2009 2010 Q311
a

AB other(a) AB discounted bill-related Asset-backed (AB) loan-related

A large portion of these were previously grouped with discounted bill WMPs Source: Wind Information

Explaining the Numbers

In the past, Fitchs analysis of Chinese banks wealth management offerings focused solely on loan- and discounted bill-related products due to concerns about the understatement of credit growth and credit exposure, as well as hidden credit risk. However, the agency has now expanded its analysis to the entire universe of products issued to gain a better understanding of the full extent of the liquidity pressures from this activity. The CNY7.7trn figure above relates to total outstanding products sold publicly and captured by third-party data provider Wind Information. Excluded from this number are all WMPs that have matured, all unobserved products sold in private placements, which are believed to be significant, all issuance by foreign banks (which had 1,443 products outstanding in Q311), and all issuance not disclosed by banks to Wind. The estimate above differs dramatically from a recent figure from the PBOC that placed the size of wealth management activity at CNY3.3trn at end-Q311. However, the PBOCs number relates only to those WMPs sitting off-balancesheet, whereas Fitchs estimate includes all WMPs outstanding both on- and off-balance-sheet. While substantial, CNY7.7trn does not adequately reflect the full extent of payout pressures arising from WMP activity in 2011 as it excludes the more than 8,300 products that were issued and matured between January 1 and September 30. Every product that matures represents a cash payout obligation for the issuing bank. In total, more than CNY12trn in products matured through end-Q311. Scenario 1 in the earlier cash flow analysis assumed that banks managed to roll over 40% of maturing WMPs, and were required to only pay out 60% of the obligations. While this ratio may seem high given the very short-term nature of such products, WMP investors are highly rate-sensitive and mobile, and retaining this money over the long haul can be quite difficult.

Some On-, Some OffAs highlighted earlier, the constant movement of WMPs on- and off-balance-sheet is adding significant volatility and distortions in numerous institutional- and system-wide data. However, it is important to note that not all WMPs move back-and-forth. Every WMP begins its life onbalance-sheet during the brief time when money is collected from investors. But following this period, principal-guaranteed products must remain on-balance-sheet, while non-principal-

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guaranteed products may be moved off until maturity if the bank so chooses. It is through this strategic setting of product start and end dates that banks are able to control the flow of WMP assets and liabilities on- and off-balance-sheet.
Figure 21

Average Product Size

Mixed-Loan Products
State banks Joint-stock banks Other banks

Discounted Bill Products

State banks Joint-stock banks Other banks

Other Asset-Backed Products

State banks Joint-stock banks Other banks

(CNY bn) 9M11 2010 2009

(CNY bn) 9M11 2010 2009

(CNY bn) 9M11 2010 2009

0.0 0.5 1.0 1.5 2.0 2.5 3.0 Source: Wind Inf ormation

0.0

0.3

0.6

0.9

1.2

0.0

0.4

0.8

1.2

1.6

2.0

As of end-Q311, roughly 20% of outstanding WMPs were principal-guaranteed products permanently residing on-balance-sheet. Of the remainder, approximately half had yet to mature and were still off-balance-sheet, while the rest were newly launched WMPs still in the phase of collecting money, and therefore temporarily on-balance-sheet but likely to soon move off-. When an off-balance-sheet WMP matures and the money returns on-balance-sheet, the assets underlying the product do not always return with it. In some instances, banks leave the assets off-balance-sheet, and conduct a reverse repo with the WMP (resulting in a rise in deposits on the liability side of their balance sheet and reverse repos on the asset side). This means that some reverse repos are temporary shell transactions not necessarily backed by any real nearterm cash flows. Hence, some Chinese banks liquid assets may be somewhat overstated.

Product Complexity Rising

As competition for funding intensifies, the yields offered on WMPs has been climbing (Figure 23). Achieving the returns to meet these yields is leading to issuance of more complex, highrisk products, such as re-securitised products containing other banks WMPs, trust products, and products broken into risk tranches. While these types of WMPs do not appear to have exceeded more than 5% of total issuance in thus far in 2011, they highlight the pressure banks are facing to find assets commensurate with rising yields now that the CBRC has largely shut the door on issuance of credit-backed products.
Figure 22

Yield Curves
Loan-Backed Products
(%) 8 6 4 2 0 1-90 day s 91-180 day s 181-365 day s 1-2 y rs H110 H111 H210 Q311

Discounted Bill Products

(%) 5 4 3 2 1 0 1-90 day s 91-180 day s 181-365 day s 1-2 y rs H110 H111 H210 Q311

Other Asset-Backed Products

(%) 5 4 3 2 1 0 1-90 day s 91-180 day s 181-365 day s 1-2 y rs H110 H111 H210 Q311

Source: Wind Inf ormation

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Product Disclosure Still Poor
Thin disclosure remains a key source of concern. Rarely do product descriptions identify the precise make-up of assets eg corporate bond number a, issued by Company B on date c for amount d and there is no third-party validation that product descriptions match reality. Meanwhile, no information is provided on the extent of WMPs sold as private placements, no central publicly available catalog exists of WMPs issued and outstanding, and products still do not contain unique identifier codes to trace them. For these reasons, if there were to be widespread problems among WMP offerings, unwinding the products could be extremely difficult, and it is unclear to what extent banks would truly be able to impose losses on investors, who would appear to have a strong argument that critical details were never disclosed and products not fully represented. In this light, it is questionable whether WMPs should be allowed to be shifted off-balance-sheet in the first place.

Regulations Slowly Tightening

Regulatory scrutiny of wealth management offerings has intensified, and a number of new guidelines have been put in place to safeguard activity. These include bans on the inclusion of certain types of assets such as entrusted loans, enhanced guidelines on product disclosure, and a ban on issuance of products less than one month in maturity. While clearly steps in the right direction, the critical issues noted above remain unresolved, and there continues to be a gap between what is announced by regulators and what actually happens in reality due to differing interpretations of the rules and differing degrees of enforcement. The order to bring on-balance-sheet all loan-backed wealth management products by end-2011 is an example. With one month left, some banks say it remains unclear precisely which products have to be brought on-balance-sheet, eg loan-only or loan-mixed WMPs, where the assets should be recorded in financial statements, and what provisioning and capital charges are required.

Rating Implications
Since the Long-Term IDRs of Chinese banks are driven entirely by expectations of state support, they are unlikely to be affected by wealth management developments without a large shock in this activity requiring government assistance. Chinese banks VRs already incorporate the extent of each institutions participation in this activity. That said, given the rapid growth and increasing complexity of products, some VRs could be revised downward if activity were to materially increase current levels of liquidity and credit risk. Figure 24 below highlights upcoming product maturities for the 16 commercial banks under Fitch coverage.
Figure 23

Breakdown of Remaining WMP Maturities as of end-Q311

(No. of products)

Q411

Q112

Q212

H212

2013+

900 750 600 450 300 150 0 BCOM ICBC BOC CCB CEB MER BOB SPDB SZDB MIN
a

HXB ABC BOS CITIC IND

CGBOther(a)

Includes WMPs issued by more than 50 city and rural commercial banks Source: Wind Information

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